KPMG Takes Its Turn With a Big 4 -Sized Scandal

“We are not enemies, but friends. We must not be enemies. Though passion may have strained, it must not break our bonds of affection. The mystic chords of memory will swell when again touched, as surely they will be, by the better angels of our nature.” Abraham Lincoln

It’s pretty bad in the Big 4. Again.

My colleagues Dave Michaels and Michael Rapoport at the WSJ got a scoop last week that five partners and another audit employee at KPMG had been fired, including a Vice Chairman who is was the top US audit partner and the former national managing partner for audit quality and professional practice.

Big Four accounting firm improperly received information about which audits PCAOB planned to review

By Dave Michaels and Michael Rapoport

Updated April 11, 2017 10:51 p.m. ET

Five KPMG LLP partners, including the head of its audit practice, were fired after the Big Four accounting firm improperly obtained information about which audits its regulator planned to inspect, the company said.

The PCAOB also fired one employee who media reports said was allegedly the leaker.

The firm learned in late February, from an internal source, that an individual who had joined KPMG from the PCAOB subsequently received confidential information from a then-employee of the PCAOB, and shared that information with other KPMG personnel. That information potentially undermined the integrity of the regulatory process.

KPMG immediately reported the situation to the PCAOB and the SEC, and retained outside counsel to investigate. The firm learned through the investigation that the six KPMG individuals either had improper advance warnings of engagements to be inspected by the PCAOB, or were aware that others had received such advance warnings and had failed to properly report the situation in a timely manner.

Investigations continue and no SEC or PCAOB enforcement actions or disciplinary actions have been announced, yet. I expect the SEC will take the lead since the PCAOB’s processes and controls are part of the story. My WSJ colleagues got the scoop and, it is clear to me, if someone had not made the call to the WSJ we would have been waiting a long time for the SEC or PCAOB to announce something.

KPMG also says, “This issue does not impact any of the firm’s audit opinions or any client’s financial statements.”

I find that odd, unless all of the terminated partners were leadership/national office partners, currently not assigned to lead engagements. The two names revealed so far—Scott Marcello, the head of the United States audit practice and David Middendorf head of of the national office— do not appear to have been assigned as lead partners on any audits for 2016, based on the new PCAOB engagement partner database.

If that is the case, these non-client facing partners could still impact audit opinions or financial statements because they, perhaps, used the inspection information not directly for their own personal benefit but to warn or advise engagement teams to backdate workpapers, clean up files or otherwise cover up audit failures before the PCAOB caught them. The PCAOB says that when a firm does not provide sufficient evidence to support its audit opinion, then the opinion should not have been issued at all.

That would be an audit failure in my book.

I guess we will have to wait until we have more details to see whether KPMG’s statement was too optimistic, naive or regrettably incomplete.

Jim Ulvog, who pens the Attestation Blog, says, “From my auditor’s perspective, this situation has the feel of a ‘red flag’, meaning something that seems odd on the surface and which is actually a warning sign there could be a far more serious problem, potentially systemic and possibly quite material.”

I agree.

It’s not like Big 4 firm partners have never acted in their own self-interest, subverting the authority of the regulator, and corrupting more partners downstream in the process. It just happened at Deloitte Brazil. The PCAOB said in its complaint that a very senior partner of the Brazil firm knew in early 2014 that his colleagues had provided the PCAOB inspectors with improperly altered versions of the 2010 workpapers for its audit of airline Gol Linhas Aéreas Inteligentes S.A.

Back in 2002, a Brazilian auditor for Deloitte at the peak of his career questioned the firm’s Italian office about large, unusual balances between Italian dairy company Parmalat’s Brazilian operation and a Cayman Islands subsidiary called Bonlat.

Fourteen years on, that onetime whistleblower, Wanderley Olivetti, is being stripped of his responsibilities, as the most senior of 12 Deloitte partners sanctioned this week by the Public Company Accounting Oversight Board (PCAOB), the U.S. audit regulator. The board accused Olivetti of lying to it about faulty audits and a subsequent cover-up among senior partners.

After all, KPMG is the firm of Scott London, the convicted inside trader who served his own self-interest while the regional partner in charge of KPMG’s audit clients in Southern California and the southwest United States. KPMG lost the Herbalife audit to PwC as a result of London’s illegal and unethical actions. Skechers, whose CFO told the FT he bore no ill will towards London or KPMG London, also replaced KPMG as its auditor shortly after the revelations and had to re-audit two years of financials.

KPMG is also the firm that audits or audited some of the biggest bailouts, failures and forced acquisitions of the financial crisis.

KPMG was almost out of business once before, in 2005, as a result of an almost criminal indictment for tax shelter fraud. Looking into the abyss, regulators established the implicit “too few to fail” policy.

Every remaining Big 4 firm has has weathered, at one time or another, a similar critical mass of audit failures and litigation threats, sometimes verging on a full-blown crisis in confidence, in the 15 years since Arthur Andersen closed up shop and the Sarbanes-Oxley Act was passed to supposedly end all doubts about auditors.

There has been no admission, similar to the one in the UK, that meetings took place between the auditors and the Federal Reserve or the Treasury leading to Lehman’s failure or afterwards. No one has asked them. The Big 4 were never called to Congress to testify about their role during the crisis.

EY felt the heat for a short moment over the failure of Lehman Brothers. The $99 million EY paid was more than Lehman’s officers and directors paid. Dick Fuld and the rest starred in “Too Big To Fail” but he and his directors only paid $90 million. That’s a big deal considering executives typically say, “The auditors said it was ok,” and the auditors say, “Management duped us.” But, I wrote at the time that it’s not that much considering that EY agreed to pay C$117 million ($117.6 million) just before that to settle claims in a Canadian class action suit against Sino-Forest Corp, a Chinese reverse merger fraud. That settlement is the largest by an auditor in Canadian history, according to the the law firms.

Deloitte was dinged but not seriously dented by the financial crisis. The firm lost some really big audit engagements as a result of the bankruptcies and forced acquisitions that were foisted on the firms by the U.S. Treasury during the crisis, clients like Bear Stearns, Washington Mutual, Merrill Lynch and, much later, Royal Bank of Scotland.

PwC audits some big crisis players, too. JPM Chase, Bank of American and Goldman Sachs were all integral to the resolution of the crisis as well as being both bailout recipients and bailout buyers of firms like Washington Mutual, Bear Stearns, and Merrill Lynch.

JPM Chase experienced a non-crisis related failure to control, and auditor PwC didn’t make a public appearance at all. The bank booked a restatement to recognize its bungling of the disclosures surrounding its $6 billion dollar loss for the “Whale” trading debacle.

At the beginning of 2016 PwC faced three trials for its role in alleged frauds and its alleged professional negligence based on the complaints filed with courts. The first trial started last August, a hearing on PwC’s role in allegedly enabling the crisis-era failure of Taylor Bean & Whitaker while auditing Colonial Bank, TBW’s partner in crime. Both Colonial Bank and TBW went bankrupt from the frauds and sent executives to jail. PwC paid an undisclosed amount after three weeks of testimony by the plaintiff, the Trustee in bankruptcy, ostensibly to avoid a much worse result if the verdict was unfavorable to PwC and resulted in an award approaching the $6 billion damages claim.

PwC’s second trial began in early 2017 when it faced a $3 billion claim by the Trustee in bankruptcy for MF Global, a firm that collapsed in bankruptcy in October 2010. PwC again settled for an undisclosed amount after a few weeks of testimony by the plaintiff’s witnesses, including testimony by the two PwC engagement partners, Linda McGowan and George Gallagher. PwC confirmed to me at the time of the MF Global trial that both partners are still active with PwC, although neither was assigned to be a lead engagement partner for a PwC audit client in 2016, according to a check today of the PCAOB database.

Guy Rolnik, a Clinical Associate Professor of Strategic Management at the University of Chicago Booth School of Business writes in the Stigler Center’s Pro-Market blog that the global firms not only push back on the public’s expectation they will detect fraud via their audits the Big 4 even avoids admitting that they serve a public watchdog role!

Crucial to MF Global’s case is the portrayal of PwC (and other auditing firms) as public watchdogs—a definition which PwC has resisted before. In a letter to the court last month, PwC requested that MF Global’s plan administrator be precluded from referring to its role in the U.S. financial markets as a “public watchdog.” On Friday, the court agreed and barred MF Global from arguing that PwC had a public watchdog role.

The definition relies on a previous Supreme Court ruling, in the 1984 case United States v. Arthur Young, which determined that accounting firms have a “public watchdog” role that mandates they remain completely independent from clients.

PwC was also sanctioned by the New York Department of Financial Services, like Deloitte, for allegedly selling out its objectivity to Bank of Tokyo Mitsubishi according to the complaint. PwC, however, was fined 2.5X as much as Deloitte, $25 million, and banned twice as long, two years. The firm made the senior manager in charge of the engagement a partner.

In another case of failing upward, Tim Ryan, who was PwC’s engagement partner from 2005-2009 for the largest bailout and nationalization of all, AIG, is now the firm’s US Chairman.

After the crisis, three of the Big 4—all but KPMG—were actively involved in working with the big banks, the ones they didn’t audit, to support the failed foreclosure review process. KPMG, however, was of course the auditor of two banks with largest exposure to the foreclosure damages, Citigroup and Wells Fargo/Wachovia. KPMG was also, of course, the auditor of two of the worst case subprime mortgage originators, New Century and Countrywide.

There are a number of partners and professionals from the Big 4 that have been sanctioned or jailed for insider trading in the last ten years. It’s a rogues’ gallery that includes Scott London from KPMG, as well as a senior tax partner from EY, and a Vice Chairman from Deloitte. Deloitte’s former chief risk officer was also charged with accepting a loan of gambling chips from an audit client, Caesars Entertainment Corp. The SEC under Mary Jo White and the PCAOB have been more aggressive in the last few years than in the first ten years after Sarbanes-Oxley in enforcing auditor independence rules. Some of the details are too salacious to repeat on this family blog. Despite that, there are still more matters that should be on their to-do lists.

It’s a terrible joke on investors and the capital markets that PwC’s screw-up regarding Oscar envelopes got more mainstream coverage than any of the stories I mentioned previously. According to Rolnik at the Stigler Center it’s because there’s a lack of general interest in the auditors.

Eight years after the calamity and subsequent bailouts on Wall Street, the role of the auditors—and the Big Four in particular—has never been fully investigated by regulators and legislators, nor the media.

The lesson (not the moral) is simple: if we want to better understand when markets work and when they fail, we should have a better understanding of the way reputation works, especially the way large players in the market manipulate reputation using complexity and a crowded media agenda, and how the public’s lack of interest is translated into a lack of regulatory urgency.

“The auditors have proven themselves to me, over and over again, to be more concerned about the steady stream of fees than in doing their job.”

I agree with the sentiment but not his conclusion. The Big 4 are a necessary evil, with audits required by listing exchange rules and consulting used as cover by big corporations. Everyone needs someone to point a finger at once and a while. For a large fee, corporate executives will say, “The auditor said it was correct,” and the auditor will say, “We were duped,” and prosecutors, judges, politicians and many regulators will say it’s just too hard to sort it all out.

Major settlements and occasional infamy is an acceptable cost of doing business they can handle, as far as we know.

Like the big banks, no one wants to plan for the consequences of taking a Big 4 firm out for being very bad once too often. The stakes are just too high for everyone dependent on the “too few to fail” Big 4.

[…] inspectors and falsifying audit documentation to obstruct investigations. Just a few weeks ago, the WSJ reported that a PCAOB professional had given inspection information to a KPMG staff member and firm leaders […]

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Francine McKenna (@retheauditors) is the Transparency Reporter at MarketWatch.com, a Dow Jones publication, where her work is also featured frequently in the Wall Street Journal. McKenna had more than twenty-five years of experience in consulting and professional services including tenure at two Big 4 firms, both in the US and abroad before becoming a journalist. Look for her prior columns, "Accounting Watchdog" at Forbes.com and "Accountable" at American Banker. For more information, click "About" at the bottom of this page. For more information contact Francine McKenna, fmckenna@mckennapartners.com